Naïve Investors Taken to the Cleaners

I feel for people who are not investment savvy because they pay a dear price for their inexperience. The mutual fund industry and advisers who sell commission-based products take advantage of unsophisticated investors by marketing high-fee, high-commission funds that earn low returns. I wish there were a way to put a little voice in every inexperienced investor’s head that tells them, “Just buy low-cost index funds!” It would go a long way to solving this serious problem.

Javier Gil-Bazo and Pablo Ruiz-Verdu studied the relationship between mutual fund performance, management fees, commissions and flow of funds in The Relation between Price and Performance in the Mutual Fund Industry. They found strong evidence that fees paid by clients, commissions charged by brokers, and the performance of funds were all directly related to client sophistication.

Sophisticated investors are performance-sensitive and tend to select funds that have lower fees. Not surprisingly, the least sophisticated investors are buying higher cost mutual funds which sport the highest management fees and sales commissions.

Ironically, high-fee funds performed worse, even before fees. The study notes a negative relationship between before-fee, risk-adjusted returns and fees. Funds with worse before-fee performance charge higher fees than those with better before-fee performance. The existence of high fees and commissions just aggregates the problem of lower returns.

The study also found that under-performing funds had high marketing costs because they target unsophisticated investors that are more responsive to advertising. These investors are also more likely to use brokers to purchase mutual funds. Low-performing funds tend to pay high commissions to brokers and this influences their recommendation.

Gil-Bazo and Ruiz-Verdu conclude that even after controlling for a host of fund characteristics, under-performing funds charge higher marketing and non-marketing fees. They further infer that regulation has not been sufficient to ensure that fees reflect the value that funds create for investors.

The solution is education, and that’s not easy. There’s plenty of good information already available, the problem is getting people to look at it. I don’t know the answer. Perhaps a reality television show would help? Somehow a little voice needs to scream, “Just buy low-cost index funds!” every time an investor reads a hyped-up mutual fund advertisement or is pitched a high-cost fund from a broker. In the meantime, I continue to put out my blog and books and hope for the best.